With increasing use of 'blended finance' approaches, public and private financiers are joining forces in the Southern African region to invest in climate change solutions. The increased willingness of public and private investors to work together is a portent of good things to come - report Blaise Dobson and Charlotte Ellis of SouthSouthNorth.

Getting climate projects to ‘investment grade’

Responding to climate change is one of the biggest challenges of our time - and one that cannot rely solely on the public sector to deliver solutions. Private sector involvement will be crucial to the global effort. To get climate projects to ‘investment grade’ – often called ‘bankable’ projects in the commercial world – private actors must consider the design of financial models, and the appropriate selection and use of financial instruments.

Public climate funds use a range of financial instruments to attract private investment, and these vary in their complexity, application and structure. Financial instruments such as  revenue support, credit enhancement, direct investments, and insurance can de-risk investments for private actors.

Examples of financial instruments used by large multilateral climate funds like the Green Climate Fund (GCF) include grants, concessional loans, equity and guarantees. The latter three instruments are of high interest to private sector actors: they insure against uncertain revenue streams. However, that said, there is a strong argument for the use of grants. Grants can act as catalysts: e.g. in new market testing, breakthrough R&D, incubation and seed funding.

Rise of blended finance

“Blended finance” is a term used to describe a form of public private partnership focusing on catalysing long term private investment in a sector, using public and philanthropic funds to mobilise additional private capital.

The private sector’s ability to blend resources can enhance the financial feasibility of a project. The national context in which a particular instrument is used is of critical importance to effectively “blend” financial resources to address climate change.

Research shows that only US$ 2.9 billion (3.6%) of the private finance mobilised using blended finance flowed to Low Income Countries between 2012 and 2015. Despite the lack of certainty around the use of complex financial instruments in developing countries, there are increasing numbers of climate projects that take a blended finance approach. Financiers in the Southern African region are getting in on the act - we explore some of the latest initiatives, below.

Concessional loans for climate action

Concessional loans involve lower interest rates or longer payback periods on borrowing than in the open market. One example of the use of debt financing for climate-smart development was a recently approved US$ 154 million GCF project to lend money to independent power producers in Zambia. The Zambian African Development Bank (AfDB) GCF Renewable Energy Framework (FP080) seeks to support the Government of Zambia's Renewable Energy Feed-in Tariff policy to develop 100 Megawatts of renewable energy projects, mostly solar power, through long-term project loans.

The project blends three instruments: a US$ 112.5 million loan (of which US$ 50 million is from the GCF; US$ 50 million is from the AfDB and the rest from other investors), a US$ 37.5 million equity investment from project sponsors and a US$ 4 million grant (from the GCF and AfDB together). It is likely that the AfDB’s framework lending to finance renewable energy installations will continue to expand, noting that the AfDB’s entire 2017 energy investment portfolio was comprised of renewables.

Equity investments in climate projects

Equity describes an ownership stake within a project, company and/or economic asset that offers returns to investors through dividends during ownership, and/or capital growth on the asset upon sale. Investing in local, green, small and medium sized enterprises offers perhaps the most likely path to allow Southern African countries to meet their required growth trajectories, whilst embracing a net zero emissions future. Taking an ownership stake in small and growing businesses through an equity investment is one mechanism to support climate entrepreneurs.

However, the risk and transaction costs of placing these equity investments can be prohibitive unless they are bundled for investors with large amounts of capital to invest (e.g. institutional investors). The proposed Green Outcomes Fund in South Africa is one bundling mechanism that looks to incentivise existing financial intermediaries (especially private equity and venture capital firms) to consider taking on equity investments in enterprises that look to solve climate change whilst also returning a profit to their shareholders.

Guarantees for climate investments

Guarantees are risk reduction measures that make provision to ensure investors are paid out, should there be a default on loans or bonds. This can be useful, for example, in cross-border investments, where currency exchange rate risks can be high. This is especially true if the investments are in fixed, long-lived infrastructure such as renewable energy installations. Development finance institutions such as Guarantco can package credit guarantees that are used to secure long-term debt for infrastructure development, where the risk for foreign inward investment would otherwise have been too high for the private sector.

Insurance

Whilst insurance is typically not widely provided by multinational and bilateral climate financiers, there is precedent for providing grant resources to explore the establishment of insurance-type mechanisms, where these have been shown pre-feasibility potential. For example, Namibia’s Environmental Investment Fund has proposed the piloting of a crop insurance and incentive scheme that would safeguard farmers in the crop-growing regions of the Kavango East, Kavango West and Zambezi, which are water scarce. The GCF Board approved the Environmental Investment Fund’s ‘Climate Resilient Agriculture in three of the Vulnerable Extreme northern crop-growing regions’ (CRAVE) proposal in October 2016, and has disbursed almost a third of the approved US$ 9.5 million, with US$ 0.5 million co-financing from EIF. The establishment of national climate insurance mechanisms seeks to supplement African regional efforts to build sovereign disaster risk insurance (e.g. African Risk Capacity) while providing avenues for local private sector stakeholders to invest in resilience.

Use of cross-border instruments

In some instances, shared currency regimes and regional integration can allow development finance institutions to sidestep some of the lending risk created by cross-border activities. Two initiatives have been proposed by the Development Bank of Southern Africa (DBSA) to the GCF, which do exactly this:

• The DBSA has proposed the establishment of a Climate Finance Facility, which is seeking a US$ 55 million loan from the GCF, to focus on infrastructure projects that mitigate or adapt to climate change. The Facility would lend on subordinated debt and provide credit enhancements (e.g. term extension) to projects that are commercially viable, but not currently receiving finance from private sector banks in local currency. Currently, the Facility is planning to operate within Lesotho, Namibia, Swaziland and South Africa.
• Another example is Africa GreenCo, which seeks to capitalise a creditworthy, independently-managed and government co-owned intermediary off-taker for cross-border renewable energy trading in the Southern African Power Pool. The concept was shortlisted through the GCF’s Pitch for the Planet request for proposals for Mobilising Funds at Scale, under the accreditation of the DBSA, with a no-objection letter from the Zambian National Designated Authority.

While neither of these DBSA initiatives has yet secured GCF Board approval, both show promising use of instruments to advance climate finance at a regional scale in a way that crowds-in private sector investment. Success will help countries achieve ‘enhanced contributions’ under the Paris Agreement and make a significant step toward more climate compatible development.

All of the examples discussed here show how climate finance can go far beyond simple grants and loans. Southern African countries are already moving towards more strategic consideration and use of multilateral funds like the GCF. Their private sectors are beginning to support a far more ambitious response to climate change across the region.

This blog is an output of the Southern Africa Climate Finance Partnership (SACFP). The Southern Africa Climate Finance Partnership (SACFP) looks to support the development of a regional partnership programme to improve country-owned climate finance portfolios. The United Kingdom’s Department of International Development and the Swiss Agency for Development Cooperation provide financial support for the current phase of the SACFP. For more information; please contact sacfp@southsouthnorth.org.